African private equity: In search of a solid 3x

From rising to falling star, Africa rewards those with discipline, patience and the skills to build a market leader.

When the world was struggling to emerge from the financial crisis, Africa was a beacon of light. In 2013, with Europe in recession, gross domestic product growth in sub-Saharan Africa peaked at over 5 percent. In North Africa the picture was similarly rosy, with Egypt, Tunisia and Morocco all recording growth between 4 and 9 percent. Africa was the rising economic star, coming second in EY’s 2014 survey of the most attractive global investment destinations.

In a separate report that year the advisory firm confidently stated that the “growth momentum will continue”. Even the rapid fall in commodities prices through 2015 didn’t change the narrative much. In January 2016 the IMF forecast sub-Saharan Africa growth for the year at 4 percent and said it expected Nigeria – one of the engines of performance – to exceed that.

But then the reality. In 2016 growth across the region fell back to a little over 1 percent and Nigeria and Angola – two of the three largest economies in sub-Saharan Africa – plunged into recession. As a result, 2016 became the worst year of growth for the continent in 20 years. As Florent de Boissieu, a principal at sub-Saharan private equity firm Adenia Partners puts it: “Some of the stars have fallen. We still see strong interest from LPs but Africa has been through some turbulent times over the last three years. Certain countries such as Nigeria are now regarded as much more risky.”

The commodities rout continued through 2016 and had a profound impact on growth as well as some private equity investment strategies. Africa-focused private equity firm Helios Investment Partners cancelled a $300 million oil and gas sidecar it had planned for the continent. LP interest fell away and hasn’t picked up to its old levels since, says Holger Rossbach, a senior investment director at Cambridge Associates.“After the financial crisis investors were seeking additional pockets of opportunities globally and the interest level in Africa then was at its highest point.”

De Boissieu says: “It’s never been easy to raise funds in Africa compared to other countries worldwide, but it is proving to be more challenging at the moment.”  Some funds have dropped out of a market they had rushed into only a few years ago, while others are struggling. “Many funds have been unable to deliver the outperformance lined to the risk premium expected from LPs,” he adds.

The numbers bear this out. The African Private Equity and Venture Capital performance benchmark produced by Cambridge Associates shows a five-year average IRR generated by 51 Africa-focused funds of 2.85 percent, which lags a long way behind the advisory firm’s US private equity performance indicators, as well as all MSCI indexes.

Investors say the slowdown has changed dealmaking in Africa. “In this new atmosphere we need to be extremely disciplined about picking the right opportunities. Previously some players thought private equity in Africa was about capital deployment, but this is absolutely the wrong way to think about private equity, especially in Africa,” says de Boissieu. “Some firms selected bad investments thinking that to be number three or four in the market will still get them a return, but this is wrong.”

He says the key to investing in Africa is market position. “You need to be the leader. When you are the leader you have pricing power, you can out-invest your competitor, you can buy better, you can execute better.”

Rossbach echoes de Boissieu, saying expectations around performance have been too high. “It took African managers longer to implement changes and drive value creation in the underlying companies than they originally thought when they made these investments. Reaching those target multiples took longer,” he says.

And the performance numbers suggest investors need to be more patient, with a nine-year return clocking in at 5.39 percent. “Exit markets are about timing and in Africa we have seen periods of time where companies were ready for an exit but the overall market conditions meant you couldn’t get the EBITDA multiple so managers had to wait another two or three years,” Rossbach says. From 2008 to 2016 holding periods went from less than four years to nearly eight years.

Patience is critical. Private equity investors say there are opportunities to build market leaders and secure strong returns in a way unique to Africa – by creating a company from scratch.“Because economies are less well formed in sub-Saharan Africa you have white space where there is a need to build and create a business because no company is meeting a certain need,” says Alykhan Nathoo, a partner at Helios Investment Partners. “We’ve done this in telecom towers and student accommodation. In sub-Saharan more than in north Africa as an investor you need to think about the creation of a business.”

The key, he says, “is not finding the white space. The key is finding the right team to build a business to fill that space”.

GO MODULAR

Nathoo says this ‘white space’ opportunity necessitates a particular style of capital investment. “When building a business from scratch the key is to find a business model that’s proved itself elsewhere and then take a modular investment approach. What that means is you don’t put all the capital in upfront. For example on the telecoms towers business (in 2009 Helios created Helios Towers, one of Africa’s largest telecommunications infrastructure businesses) we invested in a modular fashion ie, $10 million first, then when concept was proven another $10 million and then when further milestones were hit another $10 million. This leads to a feedback loop that helps fine-tune the parameters for the next tranche of investment.”

While strong return stories exist, investors caution even these can be threatened by an unstable macro environment, especially the currency fluctuations of recent years. “Currency is one of the key killers,” says Rossbach. “Entry and exit valuations in a number of African markets are very competitive and the macro environment is strong but currency fluctuations impede deals.”

Nathoo says “macro stability in terms of currency stability is an impediment – necessitating the need to think very carefully about investing in businesses which have some explicit or implicit currency hedge to protect against this volatility.”

Size, de Boissieu suggests, is one of these hedges. “We have experienced tremendous depreciation in some countries. Those who can survive have to be able to pass part of the increase to the customer, and this depends on the pricing power and on the market share you have.”

In such a complex and varied investment landscape, and with GDP growth across Africa not forecast to rise much above 3 percent in the coming years, what does good performance look like? “We typically look at deals with strongly covered downside and cash-on-cash multiple of 3x or so,” says de Boissieu, who warns that promises of blockbuster returns come with a sting in the tail: “When I see people talking 5x or 10x money I don’t understand where they see this in Africa and I am worried about the level of risk they are accepting.”